LIVING ANNUITIES

Inevitable trade-offs

Such are the choices on retirement, and the potential pitfalls in making them,
that trustees must at least ensure their fund members are properly advised.
Brandon Furstenburg shows why.

Much debate about retirement centres on
the “accumulation phase”, the period of
saving for retirement while one works up to
the date of actual retirement. Less attention is paid to
the period after, sometimes called the “decumulation
phase”.

Nobody wants to
spend a lifetime saving
and then commit an error
at retirement by making
a pension choice later
regretted. On retiring, few
people choose to purchase
a conventional annuity
from an insurer (a fixed
or escalating annuity that
ensures the retiree’s monthly
income until death). Most
choose a “living annuity”.

Here, in plain words,
your money stays invested
in the market. You choose
how much you want your
monthly pension to be by
selecting an annual drawdown
percentage between
the regulated 2,5% and 17,5%. This article focuses on some straightforward
things to be noted about living annuities.

First, retirees bear the longevity risk i.e. the risk
that they effectively run out of money before they die.
The maths behind a living annuity means that one can
never actually run out of money, but for all intents and purposes your monthly
pension could be reduced
to virtually zero if you
live to a ripe old age.

1 Assumptions: R1m initial investment at retirement, 8% annual return a er expenses,
in ation at 5% p.a. Drawn down rates can be varied only once annually. A less
generous net annual return will reduce the monthly pension. e principles though
remain the same.

Second, this directly
links to the fact that
a larger draw-down
percentage selected by a
retiree means that he’ll
get a bigger pension, but
it doesn’t last as long as
if he selected a lower
pension (draw-down)
to begin with. Consider
the example of one’s monthly pension adjusted for
inflation for the years after retiring at different living
annuity draw-down rates (see Graph 1).

It applies to a person who selects a living annuity,
invests R1m worth of capital and tries to keep his
monthly pension in real terms the same for as long as
possible before he is forced to reduce it (either because
he is not allowed by law to draw down more than
17,5% a year or because the value remaining in his
fund is too low).

If this person elects a 12,5% draw-down rate, he
can get a monthly pension of R10 417. But he can
only sustain this level for less than five years before
he is rapidly forced to reduce it. By the tenth year
after retirement, his pension will only be about R3
500. It represents a huge drop in living standards. If
the person believes that he may still live a long time,
barring accident, then such a drawn-down rate may be
way too high.

However, if this person elects a draw-down rate of
5%, he can sustain his initial level of pension for much
longer, albeit at a lower monthly level of R4 167. He
will only be forced to reduce his real monthly pension
from about the 25th year after retirement. The rate at
which he is forced ultimately to reduce his monthly pension is also a lot more gradual than someone who
had selected a much higher drawn-down rate.

Costs are critical. So too are the assumptions built
into any analysis. The risk inherent in the assumptions
-- for example, that investment returns are lower than
assumed – implies that one’s pension draw-down will
be affected.

Third is the impact of inflation. The difference
between the nominal monthly pension at a 5%
draw-down versus its real value, adjusted for a 5%
annual inflation rate, means that the pension must be
increased each year for its purchasing power to remain
the same (see Graph 2 where the blue line indicates the
needed increase).

Inevitably, there will be trade-offs when thinking
about choices at retirement. Retirement and annuity
products offer different things. For fund trustees, the
clear message is in the care they exercise during the
accumulation.

They should also ask themselves whether their
fund is doing enough for those retiring from it, at least
in terms of providing information about choices, and
not leaving them purely to their own devices.